Solutions Manual
CHAPTER 11
UNDERSTANDING FINANCIAL STATEMENTS
SUGGESTED ANSWERS TO THE REVIEW QUESTIONS AND PROBLEMS
I. Questions
1. The four financial statements contained in most annual reports are the
balance sheet statement, statement of comprehensive income, statement
of stockholders’ equity, and statement of cash flows.
2. Bankers and investors use financial statements to make intelligent
decisions about what firms to extend credit or in which to invest,
managers need financial statements to operate their businesses
efficiently, and taxing authorities need them to assess taxes in a
reasonable way.
3. No, because the ₱20 million of retained earnings would probably not be
held as cash. The retained earnings figure represents the reinvestment of
earnings by the firm over its life. Consequently, the ₱20 million would
be an investment in all of the firm’s assets.
4. The balance sheet shows the firm’s financial position on a specific date,
for example, December 31, 2011. It shows each account balance at that
particular point in time. For example, the cash account shown on the
balance sheet would represent the cash the firm has on hand and in the
bank on December 31, 2011. The income statement, on the other hand,
reports on the firm’s operations over a period of time, for example, over
the last 12 months. It reports revenues and expenses that the firm has
incurred over that particular time period. For example, the sales figures
reported on the income statement for the period ending December 31,
2011, would represent the firm’s sales over the period from January 1,
2011, through December 31, 2011, not just sales for December 31, 2011.
5. Investors need to be cautious when they review financial statements.
While companies are required to follow the financial reporting standard,
managers still have quite a lot of discretion in deciding how and when to
report certain transactions. Consequently, two firms in exactly the same
operating situation may report financial statements that convey different
11-1
Chapter 11
Understanding Financial Statements
impressions about their financial strength. Some variations may stem
from legitimate differences of opinion about the correct way to record
transactions. In other cases, managers may choose to report numbers in a
way that helps them present either higher earnings or more stable
earnings over time. As long as they follow the financial reporting
standard, such actions are not illegal, but these differences make it harder
for investors to compare companies and gauge their true performances.
Unfortunately, there have also been cases where managers overstepped
the bounds and reported fraudulent statements. Indeed, a number of
high-profile executives have faced criminal charges because of their
misleading accounting practices.
6. The earnings (less dividends) reported in the income statement is
transferred to the ownership section of the balance sheet as retained
earnings. Thus, what we earn in the income statement becomes part of
the ownership interest in the balance sheet.
7. The balance sheet is based on historical costs. When prices are rising
rapidly, historical cost data may lose much of their meaning particularly
for plant, equipment and inventory.
8. The income statement and balance sheet are based on the accrual method
of accounting, which attempts to match revenues and expenses in the
period in which they occur. However, accrual accounting does not
attempt to properly assess the cash flow position of the firm. The
statement of cash flows fulfills this need.
9. The three primary sections of the statement of cash flows are:
a) Cash flows from operating activities
b) Cash flows from investing activities
c) Cash flows from financing activities
The payment of cash dividends falls into the financing activities
category.
11-2
Understanding Financial Statements
Chapter 11
10. Free cash flow is equal to cash flow from operating activities:
Minus:
Capital expenditures required to maintain the productive
capacity of the firm
Minus:
Dividends (required to maintain the payout on common
stock and to cover any preferred stock obligation)
The analyst or banker normally looks at free cash flow to determine
whether there are sufficient excess funds to pay back the loan associated
with the leveraged buy-out.
11. Interest expense is a tax deductible item to the corporation, while
dividend payments are not. The net cost to the corporation of interest
expense is the amount paid multiplied by the difference of one minus the
applicable tax rate.
12. CURRENT (C) ; NONCURRENT – (NC)
Retained earnings
Accounts payable
Prepaid expenses
Plant and equipment
Inventory
Common stock
NC
C
C
NC
C
NC
Bonds payable
Accrued wages payable
Accounts receivable
Capital in excess of par
Preferred stock
Marketable securities
13. Sales
Cost of Goods Sold
Gross profit
Selling and administrative expense
Depreciation expense
Operating profit
Interest expense
Earnings before taxes
Taxes
Earnings after taxes
Preferred stock dividends
Earnings Available to Common Stockholders
Shares Outstanding
Earnings per share
11-3
NC
C
C
NC
NC
C
Chapter 11
Understanding Financial Statements
14.
Increase in accounts receivable
Increase in notes payable
Depreciation expense
Increase in investments
Decrease in accounts payable
Decrease in prepaid expenses
Increase in inventory
Dividend payment
Increase in accrued expenses
Decreases cash flow (use)
Increases cash flow (source)
Increases cash flow (source)
Decreases cash flow (use)
Decreases cash flow (use)
Increases cash flow (source)
Decreases cash flow (use)
Decreases cash flow (use)
Increases cash flow (source)
15.
1.
2.
3.
4.
Balance Sheet (BS)
Income Statement (IS)
Current Assets (CA)
Fixed Assets (FA)
Indicate whether
Items is on
Balance Sheet
(BS) or Income
Statement (IS)
BS
IS
BS
BS
BS
BS
BS
IS
IS
BS
BS
BS
BS
IS
IS
BS
BS
IS
5. Current Liabilities (CL)
6. Long-term Liabilities (LL)
7. Stockholders’ Equity (SE)
If on Balance
Sheet,
Designate
which
Category
SE
CA
SE
SE
LL
CL
CA
CL
CA
FA
CA
CL
11-4
Item
Retained earnings
Income tax expense
Accounts receivable
Common stock
Capital in excess of par value
Bonds payable
Notes payable
Net income
Selling and administrative expenses
Inventories
Accrued expenses
Cash
Plant and equipment
Sales
Operating expenses
Marketable securities
Accounts payable
Interest expense
Understanding Financial Statements
BS
II. Problems
CL
Chapter 11
Income tax payable
Problem 1 (Balance Sheet)
From the data given in the problem, we know the following:
Current assets
Net plant and
equipment
Total assets
₱ 500,000 Accounts payable and
accruals
Notes payable
2,000,000 Current liabilities
Long-term debt
Total common equity
Total liabilities and
₱2,500,000 equity
₱ 100,000
150,000
₱ 250,000
750,000
1,500,000
₱2,500,000
a. We are given that the firm’s total assets equal ₱2,500,000. Since
both sides of the balance sheet must equal, total liabilities and equity
must equal total assets = ₱2,500,000.
b. Total assets = Current assets + Net plant and equipment
₱2,500,000 = Current assets + ₱2,000,000
Current assets = ₱2,500,000 – ₱2,000,000
Current assets = ₱500,000
c. Total liabilities and equity = Current liabilities + Long-term debt +
Total common equity
₱2,500,000 = Current liabilities + ₱750,000 + ₱1,500,000
₱2,500,000 = Current liabilities + ₱2,250,000
Current liabilities = ₱2,500,000 – ₱2,250,000
Current liabilities = ₱250,000
d. Current liabilities = Accounts payable and accruals + Notes payable
₱250,000 = Accounts payable and accruals + ₱150,000
Accounts payable and accruals = ₱250,000 – ₱150,000
Accounts payable and accruals = ₱100,000
e. Net working capital = Current assets – Current liabilities
Net working capital = ₱500,000 – ₱250,000
Net working capital = ₱250,000
11-5
Chapter 11
f.
Understanding Financial Statements
Net operating working capital = Current assets – (Current liabilities –
Notes payable)
Net operating working capital = ₱500,000 – (250,000 – ₱150,000)
Net operating working capital = ₱400,000
Problem 2 (Statement of Stockholders’ Equity)
NI = ₱50,000,000; R/EY/E = ₱810,000,000; R/EB/Y = ₱780,000,000;
Dividends = ?
R/EB/Y + NI – Div = R/EY/E
₱780,000,000 + ₱50,000,000 – Div = ₱810,000,000
₱830,000,000 – Div = ₱810,000,000
₱20,000,000 = Div.
Problem 3 (Book Value and P/E ratio)
Jennifer’s Apparel
a.
b.
Total assets
Current liabilities
Long-term liabilities
Stockholders’ equity
Preferred stock
Net worth assigned to common
₱800,000
150,000
120,000
₱530,000
65,000
₱465,000
Common shares outstanding
30,000
Book value (net worth) per share
₱15.50
Earnings available to common
Shares outstanding
Earnings per share
₱48,000
30,000
₱1.60
P/E ratio x Earnings per share = Price
15
x
₱1.60
= ₱2400
c.
Market value per share (price) to Book value per share
₱24.00 ÷ ₱15.50 = 1.55
11-6
Understanding Financial Statements
d.
Chapter 11
2 x Book value per share = Price
2 x
₱15.50
= ₱31.00
Price
Earnings per share
₱31.00
₱1.60
= P/E
= 19.375 P/E ratio
round to 19
Problem 4 (Determination of Profitability)
Red Book Inc.
Statement of Comprehensive Income
Sales (1,300 books at ₱650 each)
Cost of goods sold (1,300 books at ₱450 each)
Gross Profit
Selling expense
Depreciation expense
Operating profit
Interest expense
Earnings before taxes
Taxes @ 20%
Earnings after taxes
₱845,000
585,000
260,000
20,000
60,000
180,000
35,000
145,000
29,000
₱116,000
Problem 5 (Determination of Profitability)
Toyota Auto Shop
Statement of Comprehensive Income
a.
Sales
Cost of goods sold (70% of sales)
Gross profit
Selling and administrative expense
(12% of sales)
Depreciation
Operating profit
Interest expense
Earnings before taxes
Taxes @ 30%
11-7
₱700,000
490,000
210,000
84,000
10,000
116,000
8,000
108,000
32,400
Chapter 11
b.
Understanding Financial Statements
Earnings after taxes
Sales
Cost of goods sold (66% of sales)
Gross profit
Selling and administrative expense
(14% of sales)
Depreciation
Operating profit
Interest expense
Earnings before taxes
Taxes @ 30%
Earnings after taxes
₱ 75,600
₱750,000
495,000
255,000
105,000
10,000
140,000
15,000
125,000
37,500
₱87,500
Analysis: Ms. Lim’s idea will increase profitability.
Problem 6 (Determination of Earnings and Earnings per Share)
Angelique Corporation
a.
Retained earnings, Dec. 31, 2012
Less: Retained earnings, Dec. 31, 2011
Change in retained earnings
Add: Common stock dividends
Earnings available to common stockholders
b.
Earnings per share =
₱75,000
20,000 shares
₱450,000
400,000
50,000
25,000
₱ 75,000
= ₱3.75 per share
Problem 7 (Construction of Income Statement and Balance Sheet)
Shadow Corporation
2012 Income Statement
a.
Sales
Cost of goods sold (60%)
Gross profit
Selling and administrative expense
Depreciation expense (8%)
Operating profit (EBIT)
Interest expense
Earnings before taxes
11-8
₱220,000
132,000
88,000
22,000
20,0001
46,000
8,0002
38,000
Understanding Financial Statements
Taxes (20%)
Earnings after taxes (EAT)
8% x ₱250,000 = ₱20,000
2
(10% x ₱20,000) + (12%Preferred
x ₱50,000) stock
= ₱8,000
dividends
Earnings available to common stockholder
1
Chapter 11
7,600
30,400
2,000
₱24,800
Shares outstanding
10,000
Earnings per share
₱2.84
Shadow Corporation
2012 Statement of Retained Earnings
b.
Retained earnings balance, Jan. 1, 2011
Add:
Earnings available to common
stockholders, 2011
Deduct: Cash dividend declared in 2011
Retained earnings balance, Dec. 31, 2012
₱ 80,000
28,400
8,400
₱100,000
Shadow Corporation
2012 Balance Sheet
c.
Assets
Current assets
Cash
Accounts receivable
Inventory
Prepaid expenses
Total current assets
Fixed assets
Gross plant
Accumulated depreciation
Net plant
Total assets
Liabilities and Owners’ equity
Liabilities:
Accounts payable
Notes payable
Bonds payable
11-9
₱10,000
16,500
27,500
12,000
₱66,000
285,000
(70,000)3
215,000
₱281,000
₱15,000
26,000
40,000
Chapter 11
Understanding Financial Statements
Total liabilities
Owners’ equity:
3
₱50,000 + ₱20,000 = ₱70,000
Common stock
Paid in capital in excess of par
Retained earnings
Total equity
Total liabilities and equity
₱81,000
₱ 75,000
25,000
100,000
₱200,000
₱281,000
Problem 8 (Statement of Cash Flows)
Maris Corporation
Statement of Cash Flows
For the Year Ended December 31, 2012
Cash flows from operating activities:
Net income (earnings after taxes)
Adjustments to determine cash flow
from operating activities:
Add back depreciation
Increase in accounts receivable
Increase in inventory
Decrease in prepaid expenses
Increase in accounts payable
Decrease in accrued expenses
Total adjustments
Net cash flows from operating activities
₱250,000
230,000
(10,000)
(30,000)
30,000
250,000
(20,000)
450,000
₱700,000
Cash flows from investing activities:
Decrease in investments
Increase in plant and equipment
Net cash flows from investing activities
10,000
(600,000)
Cash flows from financing activities:
Increase in bonds payable
Preferred stock dividends paid
Common stock dividends paid
Net cash flows from financing activities
60,000
(10,000)
(140,000)
Net increase (decrease) in cash flows
11-10
(590,000)
(90,000)
₱20,000
Understanding Financial Statements
Chapter 11
Analysis: It should be observe that the increase in cash flows of ₱20,000
equals the ₱20,000 change in the cash account on the balance
sheet. This indicates the statement is correct.
a. Cash flows from operating activities far exceeds net income.
This occurs primarily because we add back depreciation of
₱230,000 and accounts payable increase by ₱250,000. Thus,
the reader of the cash flow statement gets important insights as
to how much cash flow was developed from daily operations.
b. The buildup in plant and equipment of ₱600,000 (gross) and
₱370,000 (net) has been financed, in part, by the large increase
in accounts payable (₱250,000). This is not a very satisfactory
situation. Short-term sources of funds can always dry up while
fixed asset needs are permanent in nature. The firm may wish
to consider more long-term financing such as a mortgage, to go
along with profits, the increase in bonds payable and the add
back of depreciation.
c. The book value per common share for both 2011 and 2012 are:
Book value
per share
=
Stockholders’ equity − Preferred stock
Common shares outstanding
Book value per
share (2011)
=
(₱1,390,000 − ₱90,000)
150,000
=
₱1,300,000
150,000
(2011)
=
₱8.67
Book value per
share (2012)
=
(₱1,490,000 − ₱90,000)
150,000
=
₱1,400,000
150,000
=
₱9.33
(2012)
11-11
Chapter 11
Understanding Financial Statements
d. The firm’s P/E ratio for 2012 is:
Market value = 2.8
P/E ratio
x ₱9.33 = ₱26.12
= ₱26.12 ÷ ₱1.60 = 16.325 round to 16
Problem 9 (Preparing a Balance Sheet)
SM Farms
Balance Sheet
September 30, 2012
a.
Assets
Cash
Accounts receivable
Land
Barns and sheds
Citrus trees
Livestock
Irrigation system
Farm machinery
Fences and gates
Total assets
₱16,710
22,365
550,000
78,300
76,650
120,780
20,125
42,970
33,570
₱961,470
Liabilities and Owners’ equity
Liabilities:
Notes payable
Accounts payable
Property taxes payable
Wages payable
Total liabilities
Owners’ equity:
Share capital
Retained earnings*
Total liabilities and equity
b.
*
₱530,000
77,095
9,135
1,820
₱618,050
₱250,000
93,420
₱961,470
The loss of an asset, barns and Sheds, from a typhoon would
cause a decrease in total assets. When total assets are decreased,
the balance sheet total of liabilities and equity must also
decrease. Since there is no change in liabilities as a result of the
Total assets, ₱961,470, minus total liabilities, ₱618,050, less share capital, ₱250,000.
11-12
Understanding Financial Statements
Chapter 11
destruction of an asset, the decrease on the right hand side of the
balance sheet must be in the retained earnings account. The
amount of the decrease in Barns and Sheds, in the equity, and in
both balance sheet totals is ₱23,800.
Problem 10 (Preparing a Balance Sheet and Cash Flow Statement;
Effects of Business Transactions)
The Tasty Bakery
Balance Sheet
August 1, 2012
a.
Assets
Cash
Accounts
receivable
Supplies
Land
Building
Equipment
and fixtures
Total assets
Liabilities and Owners’ equity
₱6,940 Liabilities:
Notes payable
₱ 74,900
11,260
Accounts
7,000
payable
16,200
67,000
Salaries payable
8,900
84,000
Total liabilities
100,000
Equity:
44,500
Share capital
80,000
Retained earnings
40,700
Total liabilities
₱220,700 and owners’ equity
₱220,700
The Tasty Bakery
Balance Sheet
August 3, 2012
b.
Assets
Liabilities and Owners’ equity
Cash
₱14,490 Liabilities:
Accounts
Notes payable
₱ 74,900
receivable
11,260
Accounts
Supplies
8,250
payable
7,200
Land
67,000
Salaries payable
8,900
Building
84,000
Total liabilities
91,000
Equipment
Equity:
and fixtures
51,700
Share capital
105,000
Retained earnings
40,700
Total liabilities
Total assets
₱236,700 and owners’ equity
₱236,700
11-13
Chapter 11
Understanding Financial Statements
The Tasty Bakery
Statement of Cash Flows
For the Period August 1 – 3, 2012
Cash flows from operating activities:
Cash payment of accounts payable
Cash purchase of supplies
Cash used in operating activities
₱(16,200)
(1,250)
₱(17,450)
Cash flows from investing activities:
None
Cash flows from financing activities:
Sale of share capital
Increase in cash
Cash balance, August 1, 2012
Cash balance, August 3, 2012
25,000
7,550
6,940
₱ 14,490
c. The Tasty Bakery is in a stronger financial position on August 3 than
it was on August 1.
On August 1, the highly liquid assets (cash and accounts receivable)
total only ₱18,200 but the company has ₱25,100 in debts due in the
near future (accounts payable plus salaries payable).
On August 3, after additional infusion of cash from the sale of stock,
the liquid assets total ₱25,750, and debts due in the near future
amount to ₱16,100.
Note to Instructor: The analysis of financial position strength in
requirement (c) is based solely upon the balance sheets at August 1
and August 3. Hopefully, students will raise many legitimate issues
regarding necessity of information about operations, rate at which
cash flows into the business, etc. In this problem, the improvement in
financial position results solely from the sale of share capital.
11-14
Understanding Financial Statements
Chapter 11
Problem 11 (Preparing Financial Statements; Effects of Business
Transactions)
The First Malt Shop
Balance Sheet
September 30, 2012
a.
Assets
Cash
₱
Accounts
receivable
Supplies
Land
Building
Furniture
and fixtures
Total assets
Liabilities and Owners’ equity
7,400 Liabilities:
Notes payable*
₱ 70,000
1,250
Accounts
3,440
payable
8,500
55,000
Total liabilities
78,500
45,500 Equity:
Share capital
50,000
20,000
Retained earnings
4,090
Total liabilities
₱132,590 and owners’ equity
₱132,590
*Total assets, ₱132,590, less equity, ₱54,090, less accounts payable,
₱8,500, equals notes payable.
The First Malt Shop
Balance Sheet
October 6, 2012
b.
Assets
Cash
₱
Accounts
receivable
Supplies
Land
Building
Furniture
and fixtures
Total assets
Liabilities and Owners’ equity
29,400 Liabilities:
Notes payable
₱ 70,000
1,250
Accounts
4,440
payable
18,000
55,000
Total liabilities
88,000
45,500 Equity:
Share capital
80,000
38,000
Retained earnings
5,590
Total liabilities
₱173,590 and owners’ equity
₱173,590
11-15
Chapter 11
Understanding Financial Statements
The First Malt Shop
Income Statement
For the Period October 1 – 6, 2012
Revenues
Expenses
Net income
₱ 5,500
(4,000)
₱ 1,500
The First Malt Shop
Statement of Cash Flows
For the Period October 1 – 6, 2012
Cash flows from operating activities:
Cash received from revenues
Cash paid for expenses
Cash paid for accounts payable
Cash for paid supplies
Cash used in operating activities
₱5,500
(4,000)
(8,500)
(1,000)
₱(8,000)
Cash flows from investing activities:
None
Cash flows from financing activities:
Cash received from sale of share capital
₱30,000
Increase in cash
Cash balance, October 1, 2012
Cash balance, October 6, 2012
₱22,000
7,400
₱29,400
c. The First Malt Shop is in a stronger financial position on October 6
than on September 30. On September 30, the company had highly
liquid assets (cash and accounts receivable) of ₱8,650, which barely
exceeded the ₱8,500 in liabilities (accounts payable) due in the near
future. On October 6, after the additional investment of cash by
shareholders, the company’s cash alone exceeded its short-term
obligations.
11-16